Biggest Find in Decades Becomes $39 Billion Cautionary Tale

By Nariman Gizitdinov - Nov 17, 2011 4:01 PM GMT+0700

After 11 years and $39 billion of investment, Exxon Mobil Corp., Royal Dutch Shell Plc (RDSA) and their partners have yet to sell a drop of oil from what was touted as the world’s biggest discovery in four decades.

Centered on a man-made island 70 kilometers (44 miles) from Kazakhstan’s coast, the Kashagan project is just months away from completion, $15 billion over budget and 8 years behind schedule. As the milestone of first oil nears, the Kazakh government is pressuring the group for a commitment on an even- bigger second phase, a project the oil companies are undecided on and one analyst says may not make money.

“The biggest worry is whether the project can ever be profitable given the huge cost escalation and start-up delays,” said Julian Lee, a senior analyst for the Centre for Global Energy Studies in London. It may be “impossible for investors to earn a return on any investment in a second phase before their contract for the field expires” in 2041.

Kashagan, which may hold enough oil to supply the world for six months, has become a cautionary tale for oil companies worldwide as they spend an estimated $20 trillion through 2035 finding supplies in ever more difficult places. Expenses mounted as engineers underestimated the complexity of drilling under a region of the Caspian Sea that’s frozen almost half the year. The government accused the partners, which are allowed to recoup spending before sharing the oil, of inflating costs.

‘Colossal’ Work

Nursultan Nazarbayev, Kazakhstan’s leader-for-life, toured Kashagan in September and declared it a “colossal” work defining his 20-year rule since the Soviet Union’s collapse, which included building a new capital city in the middle of the country’s steppe. When the oil project starts production it will be a milestone for the Central Asian republic of 16.5 million that’s four times the size of Texas.

The project is vital to Nazarbayev because the country relies on oil for 18 percent of gross domestic product and is rebuilding the economy after a devastating banking crisis. Kazakhstan’s national oil company believes expansion can be achieved by 2017. The partners in the project aren’t so ready to rush in.

“We will finish phase one and then we will look at phase two afterwards,” Peter Voser, chief executive officer of The Hague-based Shell, said in an interview at the Group of 20 Summit in Cannes, France. “It’s not immediate.”

Christophe de Margerie, CEO of France’s Total SA (FP), echoed his sentiments, saying “let’s start Kashagan one” when asked about prospects for the second phase.

Lethal Concentration

Kashagan has proved potentially lethal as well as complicated. The crude oil, locked 4,200 meters (2.6 miles) below the seabed in a highly pressurized reservoir, has a high concentration of poisonous “sour gas,” according to North Caspian Operating Co., or NCOC, the venture formed to manage the project.

Gas sensors dot the island, scanning for any leaks of the vapor, which has a 15 percent concentration of flammable hydrogen sulfide. Weekly emergency drills are carried out with the 5,500 people living and working on the biggest of five islands. That number will drop to about 250 when the first phase becomes operational.

The project’s structures are wrapped in impermeable membranes to keep contamination from the Caspian, home to seals and caviar-bearing sturgeon, and surrounded by barriers to fend off ice. The water at the site is only 3 to 6 meters deep and with low salinity and winter temperatures below minus 30 degrees Celsius (minus 22 Fahrenheit), the northern Caspian Sea freezes for almost five months of the year.

Main Partners

The geology, islands and ice and have inflated costs for the first phase to $39 billion from $24 billion estimated by the government in 2008.

The prize for the five main partners is as much as 252,000 barrels of crude a day each from peak output once the second phase is running. That kind of production is growing harder to find worldwide as existing fields age and governments in the Middle East, Russia and Latin America reserve control for state companies.

Exxon, Shell, Total, Rome-based Eni SpA (ENI) and KazMunaiGaz National Co., the state oil company, hold 16.8 percent of NCOC each. Houston-based ConocoPhillips has 8.4 percent and Japan’s Inpex Corp. (1605) 7.6 percent.

‘Big Beasts’

“The fact you had big beasts with equal shares in the project who were thus able to slow down areas where they had different views shows the Kazakh model hasn’t been an optimal one,” Stuart Joyner, an oil industry analyst at Investec Securities Ltd. in London, said. “The cost, complexity and delays have significantly impacted the economics.”

The partners aim to find a “preferred” expansion plan by the end of this year that can be sent to the government for approval, according to NCOC.

“We don’t have clarity either about the time-frame and cost or about the planned production volumes at the second stage,” Kazakh Oil and Gas Minister Sauat Mynbayev said last month.

One option is building more islands, similar to the existing 1.9 square-kilometer (0.7 square mile) manned collection hub and four surrounding structures, NCOC said. The cluster was built from 7 million metric tons of rock carried 300 kilometers from an ice-free port to the south.

Makes Sense

Expanding Kashagan makes more sense economically than halting at the first phase, KazMunaiGaz’s former Chief Executive Officer Kairgeldy Kabyldin said on Oct. 4, before he stepped down from the post. Still, there are signs that some partners may be willing to cut their losses.

ConocoPhillips (COP) Chief Financial Officer Jeff Sheets said on an Oct. 26 conference call that Kashagan is in the “general category of looking around our portfolio in places where we have maybe not long-term strategic good opportunities.”

Oil & Natural Gas Corp., India’s largest energy explorer, and GAIL India Ltd., the nation’s biggest natural-gas distributor, have made a non-binding offer for Exxon Mobil’s 16.8 percent stake in Kashagan, two people with direct knowledge of the matter said in June.

The stake may cost $6 billion, the Financial Chronicle said Oct. 17, citing an unidentified official involved in talks. D.K. Sarraf, managing director of ONGC Videsh Ltd., ONGC’s overseas unit, declined to comment on Kashagan.

Exxon ‘Speculation’

Exxon plans to remain a major investor in Kazakhstan and reports of a Kashagan exit are “speculation,” Charlie Engelmann, a Houston-based spokesman for the Irving, Texas-based company said in a statement.

There are no talks about any partners leaving the project, Andrey Sukhov, Shell’s regional head of taxation in Russia and the Caspian region, said Oct. 21.

Kashagan’s delays already forced one reorganization of the project. In 2008, Rome-based Eni gave up operatorship of the project to the newly formed NCOC, which agreed to pay higher royalties to Kazakhstan.

“After many difficulties and setbacks, and in the face of ballooning costs and much acrimony and debate, the companies had to start over and reallocate roles,” oil industry historian Daniel Yergin said in his book The Quest, published in September. “All of this has infuriated the Kazakh government, which is having to wait years longer that anticipated for Kashagan revenues to flow.”

Double Production

Kashagan may initially produce 370,000 barrels a day, which will rise to 450,000 barrels a day by 2016, Kazakhstan’s Mynbayev said Oct. 4. The expansion would more than triple that to 1.5 million barrels a day, according to President Nazarbayev. That’s almost double Kazakhstan’s current production of about 1.6 million barrels a day, about the same as Libya produced before the revolt against Muammar Qaddafi.

Completing the expansion as early as 2017 is only possible if the partners choose a plan by early next year, KazMunaiGaz National CEO Bolat Akchulakov said in an interview in Astana, the capital, on Oct. 25.

“Phase two won’t move ahead simply, it will be later than people anticipate,” Investec’s Joyner said. “Kashagan will be a million-barrel-a-day field, but from a value perspective it’s been disappointing.”

To contact the reporter on this story: Nariman Gizitdinov in Almaty at ngizitdinov@bloomberg.net

To contact the editor responsible for this story: Will Kennedy at wkennedy3@bloomberg.net